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Finance Theory

Finance Theory 44
Finance Theory II (Corporate Finance) Katharina Lewellen February 5, 2003 1¾¾¾¾ ƒƒƒ Today Preliminaries Introduction to the course Corporate finance Types of questions Course outline Course requirements Case of Unidentified Industries 2ƒƒ Preliminaries Texts − Brealey Myers, Principles of Corporate Finance, th 7 edition th − Higgins, Analysis for Financial Management, 7 edition − Case and Readings Packet Professor − Katharina Lewellen 3ƒƒ Introduction Corporate finance Investment policy How the firm spends its money (real and financial assets) Financing and payout policy How the firm obtains funds (debt, equity) and disposes of excess cash 4Balance sheet view of the firm Assets Liabilities Current Liabilities Current Assets Longterm debt Fixed Assets 1. Tangible Shareholders’ 2. Intangible Equity 5¾¾¾ ƒƒ Introduction, cont. But we also need to understand… Capital markets Types of securities (stocks, bonds, options…) Tradeoff between risk and return Pricing Taxes and government regulation 6Financial markets Financial Markets Firms Curr Debt assets Individuals Fixed Equity assets Financial Intermediaries Government 7ƒƒƒƒƒ Introduction, cont. Finance is really about value Firms Projects and real investments Securities Common characteristic Invest cash today in exchange for cash (hopefully) in the future Central question How do we create value through investment and financing decisions 8¾¾¾ ƒ Types of questions Investment and financing decisions At the end of 1999, GM had 11.4 billion in cash. Should it invest in new projects or return the cash to shareholders If it decides to return the cash, should it declare a dividend or repurchase stock If it decides to invest, what is the most valuable investment What are the risks 9¾¾¾¾¾¾ ƒƒƒ General Dynamic Major contractor in the defense industry Doing well during 1980s (cold war) Growth in sales Reasonable profitability RD and capital investment Beginning of 1990s The end of cold war Likely decline in defense spending Strategy 10General Dynamics 1,000 800 Net Inc 600 RD + Cap Exp 400 200 0 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 200 400 600 11Value of 100 invested in Jan. ‘80 500 Market 400 300 200 GD 100 0 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 12General Dynamics Investment, 1980 – 1990 RD + Capital expenditures: 3.7 billion If invested at 10: 5.5 billion Ending market value: 1.0 billion Value destroyed: 4.5 billion Sales grew from 4.7 billion to 10.2 billion Earnings in 1990 = 578 million 13¾¾ ƒƒƒƒ New strategy in 1991 William A. Anders (new CEO): Cuts capital expenditure and RD Cap. Exp. drops from 321 million in 1990 to 81 million in 1991 Sells off divisions and subsidiaries Cuts workforce Distributes cash to shareholders From 1991 through 1993, GD returns 3.4 billion to shareholders and debtholders 14General Dynamics: 1987 – 1997 1,000 CapEx + RD 800 600 400 200 0 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 200 400 Net Inc 600 15Value of 100 invested Jan. ‘91 700 600 GD 500 400 Market 300 200 100 0 1987 1988 1989 1990 1991 1992 1993 1994 16¾¾¾¾ ƒ Types of questions Investment and financing decisions Your firm needs to raise capital to finance growth. Should you issue debt or equity or obtain a bank loan How will the stock market react to your decision If you choose debt, should the bonds be convertible callable Long or short maturity If you choose equity, what are the tradeoffs between common and preferred stock 17ƒƒ Types of questions, cont. Investment and financing decisions IBM recently announced that it would repurchase 2.5 billion in stock. Its price jumped 7 after the announcement. Why How would the market have reacted if IBM increased dividends instead Suppose Intel made the same announcement. Would we expect the same price response Motorola wants to build a new chip factory in Ireland. How will fluctuations in the foreign exchange rate affect the value of the project What are the risks What actions can Motorola take to hedge the risks More importantly, should it hedge the risks What are the costs and benefits 18ƒƒƒ ¾¾¾¾ ƒƒ Our Approach What we won’t do What we will do Acquire a set of general tools Pretend to be experts in any that are crucial to sound industry, financial or other business decision Financial managers Discuss many institutional General managers aspects in detail Apply and confront them to Discuss in detail stuff you a number of real business could learn just as well cases reading a book or an article Usefulness (see “readings”) Limitations 19ƒƒƒ Outline: Theory + Applications Part I: Financing − Capital structure − Payout policy Part II: Valuation − Project valuation (FCF, PV, Real Options) − Company valuation (MA, Startups) Part III: Selected topics in corporate finance − Corporate governance − Hedging/Risk management 20ƒƒƒƒƒƒƒ The tools of finance (15.401) Time Value of Money Portfolio Theory Asset Pricing Theory Efficient Markets Hypothesis Option Pricing Theory The Concept of NoArbitrage Agency Theory (Microeconomics, Incentives and Contracts) 21¾¾¾ ƒƒƒƒ Course Requirements Class Participation (10) Case Memoranda (30) Teams up to four people Hand in all writeups except two writeups of your choice A professional memo to the decision maker Midterm (30) Final (30) 22The Case of the Unidentified Industries 23Advertising Agency Airline Commercial Bank Computer Software Developer Department Store Chain Electric Gas Utility Health Maintenance Org. Meat Packer Pharmaceutical Manufacturer Retail Drug Chain Retail Grocery Chain ABC DE F G H I J K Line Balance Sheet Percentages 1 Cash and marketable securities 5 1221443 77 9 67 19 2 Account receivables 85 55 4 15764 7 289 13 3 Inventories 0 0 1 24 43 0 22 0 13 2 12 4 Other current assets 1422462 3326 5 Plant and equipment (net) 2 7 77 55 37 71 41 9 35 17 48 6 Other assets 7 23 1535 13 29 4 1321 7 Total assets 100 100 100 100 100 100 100 100 100 100 100 8 Notes payable 62302042 0007 9 Accounts payable 18 63 3 17 18 5 13 32 15 6 5 10 Accrued taxes 2201101 3662 11 Other current liabilities 0049 17 17 12 2 1358 12 Longterm debt 7 6 29 38 0 40 29 0 19 0 15 13 Preferred stock 4 8 215 10 17 14 1601 14 Other liabilities 2053000 0000 15 Capital stock and capital surplus 2 10 11 1 3 12 5 11 24 28 16 16 Retained earnings 4 7 28 23 51 5 24 51 18 55 46 17 Total liabilities and stockholder equity 100 100 100 100 100 100 100 100 100 100 100 Selected Financial Data 18 Current assets/current liabilities 1.11 1.03 1.31 1.46 1.59 0.63 1.1 2.35 1.58 4.72 2.31 19 Cash, marketable securities and accounts receivable/current liabilities 1.1 0.97 0.98 1.4 1.49 0.4 1.04 2.28 1.5 4.59 2.03 20 Inventory turnover (X) NA NA 16.7 5.6 5.2 NA 8.6 NA 47.6 7.5 2 21 Receivables collection period 3,278 381 30 31 8 27 6 13 16 37 74 22 Total debt/total assets 0.69 0.10 0.29 0.40 0.00 0.44 0.31 0.00 0.19 0.00 0.22 23 Longterm debt/capitalization 0.09 0.24 0.40 0.57 0.00 0.66 0.48 0.00 0.32 0.00 0.18 24 Net sales/total assets 0.10 0.52 0.46 1.82 3.18 0.83 2.61 2.03 6.47 0.87 0.64 25 Net profit/net sales 0.14 0.05 0.12 0.02 0.03 0.01 0.02 0.13 0.02 0.25 0.11 26 Net profit/total assets 0.01 0.03 0.05 0.04 0.10 0.01 0.05 0.27 0.10 0.21 0.07 27 Total assets/net worth 14.10 5.84 2.31 3.61 1.85 5.77 3.43 1.62 2.39 1.21 1.61 28 Net profit/net worth 0.19 0.14 0.12 0.13 0.18 0.07 0.17 0.43 0.23 0.26 0.11 24ƒ ƒƒƒƒ Industry Groups Service providers Zero inventories Advertising agency A, B, F, H Airline Commercial bank HMO 25ƒƒƒƒ ABF H Line Balance Sheet Percentages 1 Cash and marketable securities 5 12 4 77 2 Account receivables 85 55 6 7 Group 1: 3Inventories 0000 4 Other current assets 1463 5 Plant and equipment (net) 2 7 71 9 6 Other assets 7 23 13 4 Advertising 7 Total assets 100 100 100 100 Agency 8 Notes payable 62340 9 Accounts payable 18 63 5 32 10 Accrued taxes 2203 11 Other current liabilities 0 0 17 2 12 Longterm debt 7 6 40 0 Airline 13 Preferred stock 4 8 17 1 14 Other liabilities 2000 15 Capital stock and capital surplus 2 10 12 11 16 Retained earnings 4 7 5 51 Commercial 17 Total liabilities and stockholder equity 100 100 100 100 Bank Selected Financial Data 18 Current assets/current liabilities 1.11 1.03 0.63 2.35 19 Cash, marketable securities and accounts receivable/current liabilities 1.1 0.97 0.4 2.28 HMO 20 Inventory turnover (X) NA NA NA NA 21 Receivables collection period 3,278 381 27 13 22 Total debt/total assets 0.69 0.10 0.44 0.00 23 Longterm debt/capitalization 0.09 0.24 0.66 0.00 24 Net sales/total assets 0.10 0.52 0.83 2.03 25 Net profit/net sales 0.14 0.05 0.01 0.13 26 Net profit/total assets 0.01 0.03 0.01 0.27 27 Total assets/net worth 14.10 5.84 5.77 1.62 26Identified Industries in Group 1 A Commercial Bank B Advertising Agency F Airline H Health Maintenance Organization (H.M.O.) 27ƒƒƒƒƒƒƒ CDE G I J Group 2 Line Balance Sheet Percentages 1 Cash and marketable securities 21439 67 2 Account receivables 4 15 7 4 28 9 3 Inventories 1 24 43 22 13 2 Computer 4 Other current assets 22423 2 software dev. 5 Plant and equipment (net) 77 55 37 41 35 17 6 Other assets 15 3 5 29 13 2 7 Total assets 100 100 100 100 100 100 Dept. store 8 Notes payable 02020 0 9 Accounts payable 3 17 18 13 15 6 10 Accrued taxes 01116 6 11 Other current liabilities 4 9 17 12 13 5 Electric gas 12 Longterm debt 29 38 0 29 19 0 utility 13 Preferred stock 21 5 10 14 6 0 14 Other liabilities 53000 0 15 Capital stock and capital surplus 11135 24 28 16 Retained earnings 28 23 51 24 18 55 Meat packer 17 Total liabilities and stockholder equity 100 100 100 100 100 100 Selected Financial Data 18 Current assets/current liabilities 1.31 1.46 1.59 1.1 1.58 4.72 Pharmaceutical 19 Cash, marketable securities and accounts manufacturer receivable/current liabilities 0.98 1.4 1.49 1.04 1.5 4.59 20 Inventory turnover (X) 16.7 5.6 5.2 8.6 47.6 7.5 21 Receivables collection period 30 31 8 6 16 37 22 Total debt/total assets 0.29 0.40 0.00 0.31 0.19 0.00 Retail drug 23 Longterm debt/capitalization 0.40 0.57 0.00 0.48 0.32 0.00 24 Net sales/total assets 0.46 1.82 3.18 2.61 6.47 0.87 25 Net profit/net sales 0.12 0.02 0.03 0.02 0.02 0.25 26 Net profit/total assets 0.05 0.04 0.10 0.05 0.10 0.21 Retail grocery 27 Total assets/net worth 2.31 3.61 1.85 3.43 2.39 1.21 28 Net profit/net worth 0.12 0.13 0.18 0.17 0.23 0.26 28ƒƒƒƒƒƒƒ Group 2: Inventory turnover Computer Industry Inventory software dev. turnover Dept. store I 47.6 Electric gas C 16.7 utility G 8.6 Meat packer J 7.5 Pharmaceutical manufacturer D 5.6 Retail drug E 5.2 Retail grocery K 2.0 29ƒƒƒƒƒ Group 2: Receivables collection period Computer Industry Collection software dev. period Dept. store K 74 J 37 Pharmaceutical manufacturer D 31 Retail drug E 8 G 6 Retail grocery 30ƒƒƒ Group 2: Inventory PPE Industry INV () PPE () Computer software dev. Dept. store D 24 55 K 12 48 Pharmaceutical manufacturer J 2 17 31The Identified Industries A Commercial Bank Citicorp B Advertising Agency Interpublic C Electric Gas Utility Consolidated Edison D Department Store Chain DaytonHudson E Retail Drug Chain Walgreen FAirline AMR Corp. G Retail Grocery Chain American Stores H H.M.O. U.S. Healthcare I Meat Packers IBP, Inc. J Software Developer Microsoft K Pharmaceutical Manuf. Novo Nordisk 32Any Comments Bank Advertising E G Dpt Store Drug Airline Grocery HMO Meat Software Phama. Agency Utility Chain Chain Chain Packers Developer Manuf. Line Balance Sheet Percentages 1 Cash and marketable securities 5 12 2 1 4 4 3 77 9 67 19 2 Account receivables 85 55 4 15 7 6 4 7 28 9 13 3 Inventories 0 0 1 24 43 0 22 0 13 2 12 4 Other current assets 1 4 2 2 4 6 2 3 3 2 6 5 Plant and equipment (net) 2 7 77 55 37 71 41 9 35 17 48 6 Other assets 7 23 15 3 5 13 29 4 13 2 1 7 Total assets 100 100 100 100 100 100 100 100 100 100 100 8 Notes payable 62 3 0 2 0 4 2 0 0 0 7 9 Accounts payable 18 63 3 17 18 5 13 32 15 6 5 10 Accrued taxes 2 2 0 1 1 0 1 3 6 6 2 11 Other current liabilities 0 0 4 9 17 17 12 2 13 5 8 12 Longterm debt 7 6 29 38 0 40 29 0 19 0 15 13 Preferred stock 4 8 21 5 10 17 14 1 6 0 1 14 Other liabilities 2 0 5 3 0 0 0 0 0 0 0 15 Capital stock and capital surplus 2 10 11 1 3 12 5 11 24 28 16 16 Retained earnings 4 7 28 23 51 5 24 51 18 55 46 17 Total liabilities and stockholder 100 100 100 100 100 100 100 100 100 100 100 Selected Financial Data 18 Current assets/current liabilities 1.11 1.03 1.31 1.46 1.59 0.63 1.1 2.35 1.58 4.72 2.31 19 Cash, marketable securities and 4.59 2.03 accounts receivable/current liabilities 1.1 0.97 0.98 1.4 1.49 0.4 1.04 2.28 1.5 20 Inventory turnover (X) NA NA 16.7 5.6 5.2 NA 8.6 NA 47.6 7.5 2 21 Receivables collection period 3278 381 30 31 8 27 6 13 16 37 74 22 Total debt/total assets 0.69 0.1 0.29 0.4 0 0.44 0.31 0 0.19 0 0.22 23 Longterm debt/capitalization 0.09 0.24 0.4 0.57 0 0.66 0.48 0 0.32 0 0.18 24 Net sales/total assets 0.095 0.523 0.464 1.822 3.175 0.828 2.61 2.032 6.473 0.867 0.643 33Leverage Total Debt/Total Asset Industry Industry Industry Industry Firm Mean Std Dev Median American Airlines Airlines 0.44 0.32 0.20 0.31 Dayton Hudson Department Stores 0.40 0.29 0.17 0.30 American Stores Grocery Stores 0.31 0.35 0.20 0.32 Consolidated Edison Combination Utility Services 0.29 0.35 0.05 0.35 Novo Nordisk Pharmaceuticals 0.22 0.24 0.92 0.08 IBP Meat Products 0.19 0.31 0.24 0.30 Interpublic Advertising Agencies 0.10 0.08 0.06 0.09 Walgreens Drug Stores 0.00 0.24 0.18 0.27 Microsoft Prepackaged Software 0.00 0.07 0.19 0.01 US Healthcare HMOs 0.00 0.09 0.11 0.04 34Firm A Firm B Balance Sheet Cash and marketable securities 58 2 Accounts receivable 0 3 Inventories 5 52 Other current assets 3 3 Plant and equipment (net) 5 28 Other assets 30 12 Total assets 100 100 Notes payable 0 0 Accounts payable 17 28 Accrued taxes 0 2 Other current liabilities 7 15 Longterm debt 54 14 Other liabilities 0 4 Preferred stock 0 0 Capital stock and capital surplus 47 29 Retained earnings (25) 9 Total liabilities and stockholder equity 100 100 35